November 25, 2008

How should we think about the monetary transmission mechanism?

That’s always a relevant question, but it takes on some added importance in times like these when the federal funds rate—the standard policy target for the Federal Open Market Committee—approaches its lower bound of zero. The recent introduction of a policy to pay banks interest on the reserves they hold on account with the Federal Reserve—which presumably (though puzzlingly not yet operationally) puts a floor on the federal funds rate independent of how much liquidity the central banks pumps into the economy— raises the question afresh.

A week or so back, Glenn Rudebusch, associate research director at the San Francisco Fed, offered his view on this topic:

“Although the funds rate target cannot be lowered much further—and certainly not below zero—it is not the case that the Federal Reserve is necessarily 'on hold.' Indeed, the Fed has already started to employ alternative means for conducting monetary policy in order to stimulate the economy.

“There are three key strategies for a central bank to stimulate the economy when short-term interest rates are fixed at zero or near zero. The first is to attempt to lower longer-term interest rates and boost other asset prices by managing market expectations of future policy actions. Specifically, a credible public commitment to keep the funds rates low for a sustained period of time can push down expectations of future short-term interest rates and lower long-term interest rates and boost other asset prices. Such a public commitment could be unconditional, such as 'maintained for a considerable period' or it could be conditional, such as 'until financial conditions stabilize.' The FOMC made such a commitment in 2003 after the funds rate was lowered to 1 percent and the economy remained weak. With the funds rate currently quite low, the Fed may revisit this strategy. If so, there would appear to be considerable scope for such a strategy to work, as the 10-year U.S. Treasury bond yield remains around 4 percent. When the Bank of Japan promised in 2001 to keep its policy rate near zero as long as consumer prices fell, it was able to help push the rate on 10-year government securities down below 1 percent.”

Rudebusch goes on to discuss the other two strategies—worth reading and examining here at a later time—but I think it is interesting to contrast this first statement of strategy with the following, from Tobias Adrian and Hyun Song Shin (of the Federal Reserve Bank of New York and Princeton University, respectively):

“We find that the level of the Fed funds target is key. The Fed funds target determines other relevant short term interest rates, such as repo rates and interbank lending rates through arbitrage in the money market. As such, we may expect the Fed funds rate to be pivotal in setting short-term interest rates more generally. We find that low short-term rates are conducive to expanding balance sheets. In addition, a steeper yield curve, larger credit spreads, and lower measures of financial market volatility are conducive to expanding balance sheets. In particular, an inverted yield curve is a harbinger of a slowdown in balance sheet growth, shedding light on the empirical feature that an inverted yield curve forecasts recessions.”

“These findings reflect the economics of financial intermediation, since the business of banking is to borrow short and lend long…

“… our results suggest that the target rate itself matters for the real economy through its role in the supply of credit and funding conditions in the capital market. As such, the target rate may have a role in the transmission of monetary policy in its own right, independent of changes in long rates.”

Interestingly, the “considerable period of time” episode referred to in the Rudebusch excerpt above coincided with an increase in long-term interest rates and a steepening of the yield curve:

So, if stimulative monetary policy is what we are after, should we be looking for lower long-term rates or higher long-term rates? Discuss.

By David Altig, senior vice president and director of research at the Atlanta Fed

Because of the Thanksgiving holiday, today’s posting will be the only macroblog posting for this week.

Comments

I think there is much validity to the argument that a steepening yield curve is a key ingredient to jumpstarting economic activity. Ideally, 300 basis points or more between the 30-yr bond and 3-mo T-bill is enough to encourage lenders to borrow short and lend long in a risky environment. I think the lack of a clear policy commitment is having a negative impact in this panic-driven environment. I am looking for the Fed to lay out in clear terms how they intend to loosen policy going forward given the real limitations of impending ZIRP.

Once a clear monetary policy is established, participants will be able to take actions without fearing unanticipated Fed (re)actions to market conditions could hurt them. The more transparency and clear direction, the better if we expect lenders to take risk.

If we are trying to increase bank capital, higher long term interest rates would allow banks to borrow short and lend long with a larger net interest margin.

If we are trying to stimulate investment, lower long term interest rates would encourage companies to borrow to increase productive capacity.

Given the dangers of deflation and the fact that we are not using the productive capacity we have, we should adopt the first policy. Until banks have the confidence to lend to companies and individuals with good credit ratings, the level of short term interest rates will have no effect on economic performance.

I think at this time, it is critical that the Fed keep rates low. Once the economy shows signs of life, they can begin ratcheting them up. The last chart is interesting. If you think about the explosion of leverage in the market, it may account for the steepening of the curve. Because hedge funds, and investment funds could get better returns in the market, they were voracious borrowers to get more cash to get more return.

The amount of subprime/alt-a activity also increased significantly from 2001-2007, and I believe the velocity of that increase was steeper from 04-07 (would have to check) This could also account for the steepening.

As an aside, there was a trade in the 30 year bond option last week. An out of the money strike traded for half a tick-effectively pricing the 30 year at 0%. That should give anyone a shudder.

We know how the Fed used to run monetary policy and we know how short-term interest rates used to work. But I don't think the past should be treated as a good indicator of the future in the current environment. I think the Fed should be preparing for the possibility that changes in the target rate have a minimal effect on any interest rates of more than one year duration.

Of course, by all means try Rudebusch's public commitment method -- just make sure you have a plan B in case it doesn't work.

We want LOWER longer term interest rates. I'm perplexed that you should ask.

Preventable foreclosures are a key issue we are addressing. To the extent they are tied to 10-year Treasury rates, lower rates obviously help keep people in their homes.

In a time of massive deflation that will be caused by extraordinary debt overhangs and a worldwide COLLAPSE in consumer demand, to argue whether higher longer term rates would exacerbate or ameliorate the situation poses serious questions about the fundamental grasp of the problem.

Lower long-term interest rates. From a spending perspective, the last thing we need now, with inflation falling, is long-term interest rates rising. In other words, we want the real interest rate to fall not rise.

Isn't this the idea behind the Taylor principle? As inflation falls, lower real interest rates will help stimulate spending, which, in turn, enables the economy's readjustment back towards potential?

In fact, isn't the likelihood that the Taylor Principle may not be operable (by reaching the zero interest floor) a major reason why this recession is different from all of the other post WWII recession?

Given the dangers of deflation and the fact that we are not using the productive capacity we have, we should adopt the first policy. Until banks have the confidence to lend to companies and individuals with good credit ratings, the level of short term interest rates will have no effect on economic performance.

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I couldn't disagree more. The issue here isn't the cost of the debt. It is the fact the sheer size of debt in this country is overwhelming. This is the reason you will see deflation, (then inflation). The debt load is suffocating every asset class, especially those tied to the use of leverage. We don't need to lower the cost of the leverage artificially, in my opinion, that will not work. Debt needs to be paid down or wiped out. That is the only solution. You can take rates to zero or 1 percent Fed Funds, I don't think it will help. Corporate issuers are paying north of 10% to access the credit markets, when Fed Funds is 1.00%

I don't think taking the Funds rate to zero and keeping it there is going to change the rate corporate issuers are paying in the capital markets. Risk is finally being priced into these credits.

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November 21, 2008

Thoughts on reading the October CPI

Here is what we know about the October consumer price index (CPI). The overall index declined at an annualized rate of about 11 percent for the month—it’s sharpest fall since 1947. A plunge in gasoline prices played a big part in the decline, but that isn’t the whole story. The traditional “core” CPI, which excludes food and energy prices, also declined in October (at an annualized rate of about 1 percent). This is the first decline in the core CPI since 1982.

Let me offer an opinion on what may be behind these numbers. The drop-off in consumer prices seems to have been prompted by a number of factors, including some pass-through from sharply lower commodity prices, a stronger dollar (which makes import prices cheaper), and very soft consumer spending.

But here’s what I don’t know. Is the October CPI a sign of “deflation"? (and it would appear that many of you are interested in finding an answer to this question). Before you answer the question for me, consider the following: In order to be “deflation” the decline in prices has to be sustained and broadly based. And I’m not sure I can give you much guidance on how long the decline must be in order for it to qualify as sustained, and I sure can’t tell you how broadly-based a general decline in prices is. Consider the distribution of CPI component price changes in figure 1. About one-third of the prices in the CPI market basket declined last month, which is a fairly large percentage of the index. On the other hand, about one-third of the price index was rising in excess of 3 percent last month.

One of the things I like to consider when thinking about how “sustainable” and “general” the monthly CPI data are is to consider the behavior of the trimmed-mean estimators of the CPI. A trimmed-mean estimator is the weighted average of the CPI after some proportion of the extreme values of the index are “trimmed” away. The idea of the trimmed-mean estimator is that extreme price changes are not representative of prices in general. Moreover, there is ample evidence that the more extreme the price change, the less sustained it is likely to be.

We can trim any proportion of the data away. In fact, we can trim it all away such that only the median price change remains (this is the Cleveland Fed’s median CPI series.) Consider figure 2, which shows all the various trimmed mean estimators of the October CPI data, from a CPI that trims very little of the index to one that trims away most of the index. How much trimming provides the best perspective from which to judge how sustainable and general the monthly price data are? In the past, I’ve argued that two indicators stand out, the 16 percent trimmed-mean CPI (trimming 8 percent of the most extreme highs and 8 percent of the most extreme lows from the data) and the median CPI. I’ve highlighted these values in figure 2. While the overall CPI posted a sharp decline, the 16 percent trimmed-mean CPI posted a rather slight 0.6 percent decline, and the median CPI rose 1.8 percent.

But, admittedly, knowing which trim of the data best represents how sustainable and general a monthly price report is, is not very clear. So let me offer up a range for you to consider: the interquartile range of the trimmed-mean estimators. An interquartile range is merely the spread between the 75th and the 25th percentile of the estimators. As such, it provides a relatively stable spread of the estimators from which to gauge the range over which prices are “generally” rising (or falling.) Figure 3 shows the interquartile range of the various CPI trimmed-mean estimators monthly since 2004 compared to the traditional core CPI. The interquartile range of the October CPI data is from 0.5 percent to 1.5 percent, shown as the last vertical line in figure 3, and 1.5 percentage points above the core measure.

So when the boss asks me what I thought of the October CPI report and what does that single number tell us about inflation (or deflation), my answer is this: The overall and the core CPI posted declines for the month and clearly there is significant, rather broadly based downward pressure on retail prices. But as I cut the data, it looks to me that the October CPI data is pointing to an inflation rate somewhere in the 0.5 percent to 1.5 percent range.

By Mike Bryan, vice president in the Atlanta Fed’s research department

Mike, RE: "In order to be “deflation” the decline in prices has to be sustained and broadly based. And I’m not sure I can give you much guidance on how long the decline must be in order for it to qualify as sustained ...."

This sounds eerily like the FED's position on the rampant inflation we witnessed over a four year period (that the FED failed to report).

Isn't it time for the FED to reconsider the efficacy of its economic monitoring & reporting methodologies?

Dirtyrottenvarmint, the definition of deflation and inflation is open to debate, of course, but you can't blast Mike for using the words in the way they are curretly used most widely. If you want to talk about monetary deflation, I recommend that you qualify it with just the adjective "monetary" and speak of Mike's deflation as "price deflation".

That said, I agree with you that we have been living in a monetary deflation for some months now, and it seems only a question of time until price deflation follows.

To decide on a useful definition of "deflation", you need first to ask what you plan to use it for. In the current context, deflation matters because deflation causes expected deflation, which causes real interest rates to increase (at the zero lower bound on nominal rates) which reduces the demand for newly produced goods and services, which causes a recession and more deflation.

So define "deflation" as falling prices of an index of newly produced goods (consumption and investment) weighted by interest elasticity of demand as well as composition of GDP.

I would like to second what Matt Dubuque said in his comment. Trimmed means are probably good predictors in average times because the CPI series is highly autoregressive. CPI is most likely to be similar to what it was last month and getting rid of some of the extreme portions of the price index enhances the CPIs predictive capability.

I think we all agree that these aren't normal times. The markets and our entire economy appear to be suffering severe dislocations which I would compare to the hysteresis of a phase transition. We'll eventually revert to a new stable period, but during the dislocation normal predictors are going to be less useful than in stable times. Given the giant debt binge the country has engaged in, and the massive federal interventions in all phases of the financial system, I would predict very unusual fluctuations in the CPI over the next few years. Tough times ahead for those piloting the monetary ship of state.

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November 18, 2008

What do we know about infrastructure spending?

Recently, there’s been a great deal of discussion about developing, legislating, and implementing a second fiscal stimulus. One of the prominent components mentioned in the recent stimulus discussion is investing in infrastructure to create jobs.

The appeal of this category of spending is fairly obvious, as it represents one aspect of a stimulus package that might be expected to have a long-term benefit to the economy. A criticism has been that infrastructure spending is too slow in implementation to be a good source of short-term stimulus, but Martin Neil Baily, senior fellow at the Brookings Institution, has a couple of responses to that argument:

“… I am also aware of the objection to using infrastructure investment as a stabilization policy because it can be too slow to work. There are two ways in which this problem could be overcome: First, there is great need for improved maintenance of the infrastructure, including crumbling roads that need repair and bridges that may age prematurely or even collapse because they have not been looked after… Second, there are state and local projects that are being cancelled because of the short term budget pressures. Sustaining such projects would avoid layoffs that would otherwise take place.”

So far, so good, but then the question turns to whether public investment on infrastructure really is a good long-term social investment. As always seems to be the case, the details can be tricky. A few years back, Bates College economist and Jerome Levy Institute Scholar David Aschauer provided a good roadmap of the essential issues. There is a lot of empirical analysis in Professor Aschauer’s paper, but here is the bottom line:

“… three questions pertaining to economic growth may be asked: Does how much public capital you have matter? Does how you finance public capital matter? and, Does how you use public capital matter? The empirical results presented in this article allow affirmative answers to each of these questions. Specifically, 10% increases in either the quantity or the efficiency of public capital are estimated to increase output per capita by 2.9% over 2 decades while a 10% increase in external public debt is estimated to decrease output per capita by 1.7% over the same time frame… The main lesson to be drawn from these findings is that in formulating economic development policies, countries are well advised to pay as much attention to how public capital is financed and used as to how much public capital is accumulated.”

“Analysis of the effect of state and local government investment on state-level economic growth has provided a range of estimates, and debate about the exact magnitude of the effect continues. But most authors now seem to agree that modest increases in state public capital stocks would not dramatically raise state economic growth. In other words, that increasing public investment will not add much to a given state's ability to create jobs and wealth.

“Economists have been hesitant to give the policy advice, "Don't do it," because they recognize that some projects may have a beneficial economic effect even if the average one doesn't. They also realize that the productivity evidence does not take into account the direct household benefit of having a better infrastructure stock.”

More than most of the currently popular stimulus ideas, the benefits of increased infrastructure spending really do seem to depend critically on the specifics. Best to think about those specifics sooner rather than later.

By David Altig, senior vice president and research director, Federal Reserve Bank of Atlanta

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Comments

What type of infrastructure?

No one would argue that another Interstate would provide the value that Eisenhower's did in the 1950's.

Software is today's Interstate. We need to identify and support the types of organizations, transactions, compliance, transparency and accountability necessary for the future. This infrastructure needs to be built if we are to bridge our economies to the more innovative and competitive industries necessary to prosper.

I see the government's being a key source of funding for this necessary public work.

I suspect that this is a case where common sense will get us further than empirical analysis. Common sense issues:

Which infrastructure projects are funded matters.

Infrastructure projects that weaken state and local government financially will reduce the value of the projects.

As a country we need to balance the value of stimulating the economy with the dangers of increasing the deficit. I think we can all acknowledge that this is a difficult tightrope to walk. (But, the numeric relationships found via cross-country regression are almost undoubtedly very far off-base for our specific US case.)

Does this take into account that much of what seems to be needed right now is maintenance and repair work, rather than a lot of really new projects? (Though, locally, there's a trolley line extension that's been mandated but unfunded for years that could benefit from a few stimulus dollars being thrown this way.) Does the analysis take into account what might be lost if roads and bridges become unusable? Does that include things like schools, hospitals, etc. that might benefit from investment?

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November 14, 2008

More on the changing operational face of monetary policy

This week I’m begging your forbearance as we take a bit of a detour into the operational weeds of monetary policy. The geek factor is high, I know, but there truly have been some historic changes afoot over the past months.

To review, effective Nov. 6—as noted in Wednesday’s blog post—the Federal Reserve unwrapped a new approach to its daily operations in overnight interbank markets (in which the federal funds rate is determined). Rather than sending you scurrying down the page, here’s the deal in a nutshell:

1. The federal funds rate is the interest rate at which depository institutions borrow and lend to each other, on an overnight basis, balances (or reserves) deposited with the Fed.

2. The Fed—actually the folks who implement Open Market Operations at the Federal Reserve Bank of New York—manages the federal funds rate to an FOMC-set target by altering the total quantity of reserves available to the banking system.

3. In the old days (pre-October 6 when the Fed first began paying interest on reserves using a different interest-rate regime), these reserves paid no interest. Banks, as a consequence had every incentive to economize on their reserve balances. As a consequence of that fact, depository institutions would respond to an injection of reserves by trying to sell them off. That might work for one bank, but not the banking system as a whole, and in the end the banks would collectively have to be “persuaded” to hold the additional reserve balances. The persuading factor would, of course, be a lower federal funds rate.

4. In the new regime (post-November 6), banks can deposit reserve balances with the Federal Reserve, earning exactly the interest rate they would receive by taking those reserves and lending them out in the federal funds rate market. Beyond some point, then, an increase in reserves should have no impact on the federal funds rate, as banks should simply absorb any injection of reserves into the system. In other words, the Fed can expand the monetary base without changing the federal funds rate.

The inability to pay interest on balances held to satisfy reserve requirements essentially imposes a tax on depository institutions equal to the interest that might otherwise have been earned by investing those balances in an interest-bearing asset. Paying interest on required reserve balances effectively eliminates this tax…

Paying interest on excess balances should help to establish a lower bound on the federal funds rate by lessening the incentive for institutions to trade balances in the market at rates much below the rate paid on excess balances. Paying interest on excess balances will permit the Federal Reserve to provide sufficient liquidity to support financial stability while implementing the monetary policy that is appropriate in light of the System’s macroeconomic objectives of maximum employment and price stability.

Keister etal. expand on the idea:

The value of the payments made during the day in a central bank’s large-value payments system is typically far greater than the level of reserve balances held by banks overnight…

As a result, banks’ overnight reserve holdings are too small to allow for the smooth functioning of the payments system during the day. When reserves are scarce or costly during the day, banks must expend resources in carefully coordinating the timing of their payments. If banks delay sending payments to economize on scarce reserves, the risk of an operational failure or gridlock in the payments system tends to increase. The combination of limited overnight reserve balances and the much larger daylight demand for reserves thus creates tension between a central bank’s monetary policy and its payments policy. The central bank would like to increase the total supply of reserve balances for payment purposes, but doing so would interfere with its monetary policy objectives.

Monetary policy, in this instance, presumably means manipulating the federal funds rate, and with that the story looks more or less complete: Having removed the opportunity cost to banks of holding reserves, expansion of reserves for payments policy reasons can be accomplished without changing the fed funds rate target, and conversely the funds rate target can be changed without compromising the provision of total reserves.

I say more or less complete for a couple of reasons. The first has been highlighted by Jim Hamilton (among others): Thus far, the interest rate on excess reserves has failed to put a floor on the effective federal funds rate. Suffice it to say the puzzle has not yet been resolved:

The second issue, which has not yet generated much commentary, is exactly how we should be thinking about this separation of the federal funds rate from the provision of reserves. There is a tendency to think of monetary policy as purely linked to the federal funds rate and its direct influence on the cost of funds and, hence, capital. But as Chairman Bernanke has noted, the issue may be a bit more complicated:

Another area of pressing current interest derives from [Milton Friedman's proposition] that monetary policy works by affecting all asset prices, not just the short-term interest rate. This classical monetarist view of the monetary transmission process has become highly relevant in Japan, for example, where the short-term interest rate has reached zero, forcing the Bank of Japan to use so- called quantitative easing methods. The idea behind quantitative easing is that increases in the money stock will raise asset prices and stimulate the economy, even after the point that the short-term nominal interest rate has reached zero. There is some evidence that quantitative easing has beneficial effects (including evidence drawn from the Great Depression by Chris Hanes and others), but the magnitude of these effects remains an open and hotly debated question.

A natural corollary to that proposition would be that a large expansion of the monetary base might well constitute a change in monetary policy properly construed, even when the federal funds rate target remains unchanged. That is, the separation of money and monetary policy may not be quite as irreconcilable as it seems at first blush.

Of course, as the Chairman said, it’s an open question, and will no doubt be hotly debated. Stay tuned.

Comments

The money supply can never be managed by any attempt to control the cost of credit (e.g., if nominal interest rates are zero, etc.).

The only tool at the disposal of the monetary authorities in a free capitalistic system through which the volume of money can be controlled are "free" legal reserves.

If applied on a large enough scale, the payment of interest on reserves is an indirect method by which the FOMC can raise reserve requirements for the commercial banking SYSTEM. I.e., it will lower the "money multiplier".

The volume of inter-bank lending will be displaced, because of disproportionately larger volumes, of excess-balances:
a. excess reserve balances,
b. excess clearing balances,
c. higher pass-through correspondent balances, &
d. redistributed surplus vault cash,
(inter-bank demand deposits held in the District Reserve banks, owned by the member banks or IBDDs.

The bankers, et. al. are confused. Now the banks have effectively, idle unused lending capacity, i.e, they won't utilize their excess reserves to create new money & credit because they're now getting paid an equivalent market rate of interest (with no risk).

I.e, the commercial banking SYSTEM ends up with a much greater tax, because, as opposed to earning $208 billion dollars in earning assets on the basis of an injection of $1 billion of excess reserves (fractional reserve banking), the individual bankers now earn an interest rate equal to the FFR on $1 billion of reserves (collectively bad business).

The "monetary base" is not a base for the expansion of new money & credit. An increase in currency (trending up ever since the 1920's) drains legal reserves and would contract bank credit, unless offset by other factors supplying reserves, e.g., open market purchases of the buying type.

During 1933-1942 there was a lack of "bankable" loans (like today, not enough credit-worthy borrowers). And net debt was lower in 1939 than it was in 1929 (the essence of a depression). Between 1940-1945 net debt doubled. Virtually all that debt was Federal.

Roosevelt got his “2 percent war” by having the Fed stand ready to buy (or sell) all Treasury obligations at a price which would keep the interest rate on “T” bills below one percent, and long-term bonds around 2-2 1/2%, and all other obligations in between.

This was achieved through totalitarian means, involving the control of total bank credit and the specific rationing of that credit. Plus there were controls on prices and wages that kept the reported rate of inflation down.

Up until now this country has ameliorated its un-necessary, self-imposed, economic hardships (collapsing production), largely through massive transfer payments to non-productive recipients. Deficit financing by the Federal Government provided the principal source of funds. At some unknown point (sooner than later), there is a finite limit to this "remedy".

The future holds the prospect of sharply declining levels of consumption for the vast majority of the American people, who will be facing years of stagflation.

It is probable that we will never be able to dig ourselves out of the present morass of debt and still operate the ecnomy within the framework of a free capitalistic system.

The Fed's paying interest on reserves (required plus excess) is equivalent to allowing the Fed to print and sell unlimited quantities of T-bills. Instead of printing money to pay for assets, then selling T-bills to sterilise the money created, it allows the excess supply of money to flow back as excess reserves. So now the Fed can never "run out of ammunition", and doesn't need loans from the Treasury if it wants to undertake sterilised asset purchases.

Payment of interest on reserves creates an option for quantitative easing by eliminating the zero policy rate condition.

One rationale for desiring a QE capability apparently is the difference in demand for daylight and overnight reserves.

But QE also provides an additional mechanism for funding Federal Reserve balance sheet asset expansion, without relinquishing control over the effective Federal funds rate. And it encourages commercial banks to transmit monetary easing more broadly before the funds target rate reaches zero.

As to why the effective funds rate under the new system has deviated from target, you say “Suffice it to say the puzzle has not yet been resolved.”

Should we expect additional changes in reserve architecture?

Will events overtake this problem by further movement of the target rate toward the zero bound?

Washington - The balance in the Treasury's Supplementary Financing Account will decrease in the coming weeks as outstanding supplementary financing program bills mature. This action is being taken to preserve flexibility in the conduct of debt management policy in meeting the government's financing needs.

First, thanks for a great pair of posts. While, as you say, the subject is geeky, such changes in monetary policy are interesting and important.

While I understand _how_ the Fed can "divorce" money from monetary policy, I'd like to return to first principles and ask why would it makes any sense to interfere with a price (the fed funds rate) which presumably is conveying information to market participants. Your second point about Bernanke's view of monetary easing and asset prices is a hint, but begs the question of why the Fed is now in the business of actively influencing asset prices -- the mandate is price stability and full employment.

A second issue is that an important source of price fluctuations is due to the fact that the Fed does not have complete control over the money supply (and therefore price levels) since the ultimate money supply depends both on exess reserves and the public's preferences on deposits and currency. (I think I'm remembering this correctly from Friedman (1959).) Isn't a reserve target well-above the required reserve level (Exhibit 3) essentially introducing a large overhang of excess reserves that is potentially inflationary should the banking system decide to re-leverage?

Thanks for providing the forum for the discussion of such nerdy topics.

Tell me if I'm right on this:
With interest on excess reserves, the increase in total reserves is likely to lead to banks holding excess reserves, on about a one-to-one basis. So increases in reserves won't increase the money supply. So quantitative easing doesn't really occur.

Maybe the banks feel more comfortable lending when they have extra liquidity at the Fed, but haven't we just precluded any economic impact via monetarist mechanism?

What I don't understand is that it seems to me that this payment of interest has a practical net effect of tightening by the Fed.

I say this because while Bank A previously would have deposited fewer overnight reserves with the Fed to avoid losing the amount of interest they could have charged to Bank B via the Fed funds market, NOW they have a perverse incentive not to do so if certain conditions are met.

In other words, interbank lending is being DISCOURAGED to some extent by this move.

SOME of the funds that Bank A lent to Bank B on the Fed funds market MAY have actually been lent out to the real economy.

But NOW, that is reduced, because Bank A has larger precautionary balances with the Fed.

I think that is harmful, counterproductive and reflects a Fed policy that is unnecessarily tight when we face a surging risk of deflationary bursts.

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November 12, 2008

The changing operational face of monetary policy

“Cleveland? Yes, I spent a week there one day.” As someone who proudly called Cleveland home for seventeen years, that one’s not usually one of my favorites. But lately, I have to say, I’m getting to know the feeling. Financial markets? Yes, I spent a year there one month.

This last change may seem small and technical — and I guess in a sense it is — but it is one with some fairly consequential implications. I could explain, but I could hardly do better than the prescient article appearing in the FRBNY Economic Policy Review, written by New York Fed economists Todd Keister, Antoine Martin, and James McAndrews. If you’re a teacher — or otherwise have to explain this stuff to the uninitiated — the authors provide three mighty nice graphs. First the traditional stuff:

“We begin by examining the total demand for reserve balances by the U.S. banking system. In our stylized framework, this demand is generated by a combination of two factors. First, banks face reserve requirements. If a bank’s final balance is smaller than its requirement, it pays a penalty that is proportional to the shortfall. Second, banks experience unanticipated late-day payment flows into and out of their reserve account after the interbank market has closed. A bank’s final reserve balance, therefore, may be either higher or lower than the quantity of reserves it chooses to hold in the interbank market. This uncertainty makes it difficult for a bank to satisfy its requirement exactly and generates a ‘precautionary’ demand for reserves.

“First, note that if the market interest rate were above the penalty rate, there would be an arbitrage opportunity: banks could borrow reserves at the (lower) penalty rate and lend them at the (higher) market interest rate… As a result, the demand curve is flat . . . at the level of the penalty rate for sufficiently small levels of reserve balances…

“If the market interest rate were exactly zero, however, there would be no opportunity cost of holding reserves. In this limiting case, there is no cost at all to a bank of holding additional reserves above the fully insured amount. The demand curve is therefore flat along the horizontal axis after this point.”

Then, on to the system that became effective in the United States on October 6.

“Many central banks use what is known as a symmetric channel (or corridor) system for monetary policy implementation. Such systems are used, for example, by the European Central Bank (ECB) and by the central banks of Australia, Canada, England, and (until spring 2006) New Zealand. The key features of a symmetric channel system are standing central bank facilities that lend to and accept deposits from commercial banks…

“The new feature in Exhibit 2 is that the demand curve does not decrease all the way to the horizontal axis, but instead becomes flat at the deposit rate. In other words, the deposit rate forms a floor below which the demand curve will not fall.”

Finally, what of the world as it is today?

“Starting from the symmetric channel system presented in Exhibit 2, suppose that the central bank makes two modifications. First, the deposit rate is set equal to the target rate, instead of below it. In other words, in this system the central bank targets the floor of the channel, rather than some point in the interior. Second, the reserve supply is chosen so that it intersects the flat part of the demand curve generated by the deposit rate (Exhibit 3), rather than intersecting the downward-sloping part of the curve. Supply and demand will then cross exactly at the target rate, as desired.

“The key feature of this system is immediately apparent in the exhibit: the equilibrium interest rate no longer depends on the exact quantity of reserve balances supplied. Any quantity that is large enough to fall on the flat portion of the demand curve will implement the target rate…”

I haven’t thus far offered explanations for why these changes might be desirable and how they relate to the broader context of monetary policy generally. More on that tomorrow.

By David Altig, senior vice president and director of research at the Federal Reserve Bank of Atlanta

Could you please do a post on why the effective fed funds rate is now deviating so markedly from the target rate? There is much interest in this, but little in the way of convincing explanation from other economic blogs.

As author of one of those economics blogs that can't give a convincing explanation, let me second the request from anon above. Doesn't your graph above predict that the funds rate should never fall below the 1% earned on excess reserves?
Why is the fed funds effective at 0.35 when banks earn 1% on excess reserves? Best explanation I hear from anybody is that GSEs want to lend because they don't earn the 1%-- so far, so good. But why isn't there infinite demand from banks to borrow those funds at 0.35 and earn 1.0 for doing nothing? Best answer I've heard there is that banks don't want to expand their balance sheets because it would look like they're too leveraged if they make such a play. But if that's the story, it's terrifying to me, in that it describes a banking system so frozen that people are afraid even to pick up the $10,000 bills that are just sitting on the sidewalk.
I'd love to have someone clarify this for us.

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November 06, 2008

Underwater homeowners and foreclosure

One of the important policy questions that has developed from the recent turmoil in financial markets is, What steps should be taken to try and mitigate the rising tide of foreclosures? Many have identified “negative equity” as one of the primary culprits for the huge increase in foreclosures. Negative equity refers to the situation in which a homeowner would not be able to fully repay his mortgage from the proceeds of a sale. Mark Zandi, chief economist at Moody’s Economy.com, emphasizes the current role of negative equity in the housing crisis in a recent article.

There have been various policies put forth to try to address the negative equity issue. Perhaps the most popular is a widespread loan modification plan, in which lenders/servicers agree to write down or forgive a portion of the principal mortgage balance. A variation of this idea was included in the American Housing Rescue and Foreclosure Prevention Act of 2008. The specific plan was labeled a “rescue refinancing” package. This package consisted of a voluntary program in which a lender who agreed to write down the mortgage of a delinquent borrower to 85 percent of the current market value of the home could obtain a federal guarantee (through the FHA). The idea is basically that curing the problem of negative equity can solve the foreclosure problem.

It turns out that my colleague, Kris Gerardi, who recently joined the Atlanta Fed by way of the Boston Fed and Boston University, has conducted some research on this topic, which was discussed in yesterday’s Wall Street Journal.

“Christopher L. Foote, Kristopher Gerardi and Paul S. Willen of the Boston Federal Reserve Bank studied more than 100,000 homeowners who were underwater in Massachusetts in 1991 and found that just 6.4% of them lost their homes to foreclosure over the next three years, according to a paper published in the September issue of the Journal of Urban Economics (For non-subscribers, a version of the paper can be found on the Boston Fed’s working paper series). The vast majority of homeowners simply continued paying as usual because they focused on the affordability of their payments, not on what they owed, and they believed home values would eventually recover.”

“The economists found that homeowners typically lost their homes only after at least two things happened: Their home values dropped and they either couldn't afford the payments or they stopped making payments after losing hope that prices would eventually recover.”

“Many commentators have recently argued that lenders should eliminate negative equity for borrowers in such a position by writing down a portion of the principal balance on their respective loans. The argument runs that such a plan benefits the lender as well because the new principal balance exceeds the yield from foreclosure once one takes into account the costs of foreclosure. Many commentators have argued that this solution is so obvious that one wonders why lenders do not implement it on a large scale.”

What are the potential pitfalls?

“Think of two mistakes a lender could make. One mistake is to not offer assistance to a borrower in distress. The lender loses here if the increased probability of foreclosure, and high costs incurred by foreclosure, make inaction more costly than assistance. We call this scenario “Type I Error.” But, there is another mistake, often overlooked, which is to assist a borrower who does not need the help. The lender loses here because it receives less in repayment from a borrower who would have paid off the mortgage in full. We refer to this case as ‘Type II Error.’”

That Type II error is, according to the authors, a nontrivial problem. Using their empirical results as a basis, they conduct the following thought experiment:

“Our policy experiment here is to lower the principal so that the borrower moves from 20 percent negative equity to 10 percent positive equity. Types I and II error and net gains are measured as a percentage of the original loan balance.”

The results, as the authors say, “illustrate both the limits and the opportunities for principal reduction”:

“For most groups, Type II error is large relative to Type I error. The reason is straightforward: most borrowers will repay their loan, even if they are in negative equity positions. For the subprime single-family borrower, a 33 percent foreclosure rate implies a 67 percent repayment rate.”

There may be resolutions to this problem, but they wouldn’t be easy:

“One potential criticism of the above argument is that one could minimize Type II error by requiring proof that a borrower is likely to default. However, as a practical matter, this would be extremely difficult to enforce. Tax documents and even credit reports in many cases would not suffice, as many borrowers in need of assistance are likely suffering from very recent adverse events. Instead, policymakers would need to obtain and verify current information on income, wealth, employment status, and perhaps even more personal events, such as marital status. This would be extremely costly. Furthermore, [our results] suggest that even if qualification requirements reduced Type II error by half … [the only group for which] principal reduction makes economic sense is the multi-family, subprime borrower.”

Basically Gerardi and Willen are arguing that the key to a successful principal write-down policy would be to target the borrowers who are at the most risk of defaulting (in the absence of any assistance). For these borrowers, Type I error is high, while Type II error is very low. Their example is an owner of a multifamily property who financed the purchase with a subprime mortgage. In the Northeast, 2-4 family units are very common, where there's one owner who usually (but not always) lives in one unit and then rents out the other units. Since many of these owners relied on rental income to stay current on the mortgage, they were very susceptible to foreclosure. Further, there is an obvious externality to foreclosure on these properties, as the tenants (who have nothing to do with the delinquent mortgage) are also affected by foreclosure.

This discussion, however, is not to say that efforts to help households facing foreclosure are not effective. In fact, many organizations, from nonprofits to the U.S. government, are working to assist borrowers who face foreclosure.

Tricky business, this.

By David Altig, senior vice president and research director at the Federal Reserve Bank of Atlanta

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The Federal mortgage plan and bailout would reward the reckless and punish the prudent.

Consider the lesson it imparts to promote bailouts to the reckless. City by city, neighborhood by neighborhood, people who live beneath their means and manage money carefully will see more careless neighbors supported by federal decree. And what about the 30 percent of this nation who were smart enough to rent? Or how about the large percentage of us who have been giving warnings out to these same people the government now wants to redistribute my taxes to so they can stay in a house twice the size the home I live in. Those who are current on mortgage payments, but still squeezed, may be tempted to let two or three payments slide, so they can negotiate money-saving terms on their own mortgages. The backlash to the 700 B bailout package was not only because of the bailout of wall street but also the bailout of the reckless homeowners and their relentless ATM/HELOC spending. As it is now these people can live in their home for over a year rent free while they find a home they should have been living in from the start.

We are becoming a nation of people who feel it is not only okay but justified to cheat, lie, and swindle each other and the rest of the population. Personal responsibility is discouraged by the government and the mainstream media. White collar crimes are rarely prosecuted because FBI is so stretched. Our nation is eating ourselves from within just to keep a facade of prosperity. Hope is being replaced by anger and desperation. Welcome to the new dawn.

Indeed, almost no one seems to be addressing how the problem of widespread fraud has affected the foreclosure rate. Also, the fact that many foreclosures are likely not owner occupied--they're second homes and investment properties. Although it's not surprising to me if homeowners living in multi-unit houses are having difficulties--with house prices inflated way beyond their rent values, you can't make that scheme work.

In my opinion, market conditions are such that many Type 2 homeowners will default unless all negative equity homeowners have their mortgages written down.

The reason is that in many neighborhoods in bubble markets, prices have already declined by 40 to 50% or even more, and prices are still declining.

Take two neighbors, who both paid $500,000 for their homes in 2005. Their homes are now worth $325,000.

Borrower #1 obtained a 100% loan, and still owes $500,000. They may have even done a cash out refi in 2006 or 2007, and now owe $600,000. They have a negative net worth, and they will almost certainly default on their loan unless a huge loan modifation is done.

Borrower #2 obtained a loan for $400,000, and the $100,000 equity they once had in their property is long gone. They are now underwater by $75,000. If they see borrower #1's loan written down to under $300,000, how fair would that be? Borrower #1 would now have some equity in their property, and Borrower #2 is underwater by $75,000+, even though they were the one who put money down on their purchase. If I was borrower #2, I may stop paying on my mortgage, and take the hit to my credit, and walk away.

There is a spectrum of options available. At one end, letting them go into foreclosure, at the other principal reduction to market prices or what 'owners' can afford. Negative amortization loans can stall for time but with ownership commonly limited to seven years, likely mean an eventual short sale. As a negative, it defers the lender from recognizing their loss. Lower interest rates also stall for time but lower the likelihood of a short sale. Neither are very beneficial to the borrower which is why they may fail to induce the desired behavior, but buying time is good for the lender. Principal reduction is, but it may be too much of one since they escape any repercussions.

Unfortunately, in the Western states (and Florida) as well as elsewhere, there is the problem of the debtor/investor who claims multiple properties as a principal residence (like my sister-in-law, a nurse who just "returned" a pack of single family residences up and down the central valley of California).

This is a far greater problem than a rational thinker would imagine possible (many of her co-workers are in, or now out of, the same sinking boat). All of them would just love to take multiple fradulent bites out of your apple, and return themselves to the imagined path to a real estate empire, off of which they all feel they have been unjustly ejected.

There is a definite underlying issue with these foreclosures and that is proof of ownership of the mortgage notes.
In light if the recent "Robo Signer" scandal it is clear that most of these mortgage lenders lack the authority to foreclose.

Those who are current on mortgage payments, but still squeezed, may be tempted to let two or three payments slide, so they can negotiate money-saving terms on their own mortgages. The backlash to the 700 B bailout package was not only because of the bailout of wall street but also the bailout of the reckless homeowners and their relentless spending.

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Saving and taxes

I hope you will excuse me for trading in a bit of old news, but I’ve been thinking about a post by Greg Mankiw from last week. Titled “My Personal Work Incentives,” the item takes published details of the McCain and Obama tax proposals. The essence of the post was to point out how these details impact the return to working for higher-income individuals, assuming that a marginal dollar earned is a marginal dollar saved (for the children, of course):

“Let t1 be the combined income and payroll tax rate, t2 be the corporate tax rate, t3 be the dividend and capital gains tax rate, and t4 be the estate tax rate. And let r be the before-tax rate of return on corporate capital. Then one dollar I earn today will yield my kids:

(1-t1){[1+r(1-t2)(1-t3)]^T}(1-t4).

“For my illustrative calculations, let me take r to be 10 percent and my remaining life expectancy T to be 35 years…

“Under the McCain plan, t1=.35, t2=.25, t3=.15, and t4=.15. In this case, a dollar earned today yields my kids $4.81. That is, even under the low-tax McCain plan, my incentive to work is cut by 83 percent compared to the situation without taxes.

“Under the Obama plan, t1=.43, t2=.35, t3=.2, and t4=.45. In this case, a dollar earned today yields my kids $1.85. That is, Obama's proposed tax hikes reduce my incentive to work by 62 percent compared to the McCain plan and by 93 percent compared to the no-tax scenario.”

Since the election is over, I trust that fact will keep the focus on the essential economic point, which is that tax policy does indeed affect incentives.

Which brings me to my point. Using Mankiw’s interest rate assumption, the present value of McCain’s $4.81 is $0.17 (which is implied directly by the 83 percent marginal tax rate). The comparable figure for Obama’s $1.85 is $0.07.

Mankiw’s point is that these sorts of numbers would substantially change his incentives to work. If the whole point is to leave a little nest egg for the kids, that is surely true, but there is another choice.

Here is another possibility: Suppose I forgo provisioning for the children altogether and simply consume that extra dollar of income. That way I avoid the corporate tax, dividend and capital gain tax, and the estate tax altogether. Under the McCain plan I get to enjoy $0.65 worth of extra consumption, or $0.57 worth under the Obama plan. I would have to value my children’s consumption an awful lot to trade $0.65 (or $0.57) of my own for $0.17 (or $0.07) of theirs.

As I think about this example, I am naturally drawn to the fact that savings rates in the United States are, in an historical context, pretty darn low.

There are almost certainly multiple reasons for the pattern shown in this chart. It would be tough to make the case that tax policy is the only culprit, but it would be equally tough to argue that it is irrelevant.

The distortion on saving from capital-income taxation could be eliminated, of course, by simply eliminating taxes on saving, but doing so would have exactly the sort of distributional consequences that account for a good deal of difference in the Obama and McCain tax plans in the first place. My training as an economist gives me no special expertise in determining how to value the trade-off between “fairness” and efficiency—and beware of any economist who pretends otherwise. But as you contemplate the distortions presented by your favorite tax proposal—a required step in any complete analysis—you might consider putting disincentives to save fairly high up on the list.

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I know this was not your point, but can you literally post Mankiw's analysis without discussing how few estates are actually subject to the inheritance tax? Is there any data that suggests that even if this extremely small sliver of the population subject to the estate tax actually does work less because of "disincentives," that overall output is lower (i.e., that those not subject to the estate tax do not "pick up the slack")? Is there any data that suggests that the money sent to the government via taxation does *nothing* to benefit this hypothetical worker's children? Do the taxes paid over to the government simply go into a hole? Is it impossible that any portion of those taxes actually benefited the children? Is it impossible that some high earners take pride in paying taxes while knowing that at least some small portion of the taxes are being used to build the communities in which their children will live? Do people have absolutely no incentive to help their communities unless they get a hospital wing named in their honor? With all due respect, let's admit that the incentives argument is usually far, far more complex than any blog post will ever be able to relate.

Also, for example, a plumbing company entrepreneur with after tax NI of 250K plus would save more in taxes by hiring another worker at his newly purchased firm under the Obama than the McCain plan Since the deduction amount is higher against a higher marginal rate.

Furthermore the new worker pays payroll and income taxes which do not get dynamically scored, which means raising taxes raises employment rates AND total tax revenues. I'm sure the WSJ opinion page will cover this anomaly extensively.

However, wouldn't the analysis need to consider the implications of the two candidates' tax and spending plans on future deficits (and therefore, taxes for the children)?

In other words, I could propose a plan where we cut taxes to zero and borrow the entire federal budget. According to this analysis, that would yield a bigger inheritance and provide a greater incentive to work. But the kids doing the inheriting are going to have to pay that back through higher taxes. I worked hard, but it was a shell game. The kids just got taxed more later.

I think this analysis misses something that is missing from our political system as a whole - a clear distinction between a tax cut and a tax deferral.

Why would he pay capital gains/dividend tax on 100% of his gross investment return every year? This implies 100% turnover of his investments every year. Why does he assume the entire investment will be taxed at the estate tax rate? Why does he assume that tax rates 35 years from now will be set by either 2008 Presidential candidate?

His boldest assumption is that the long-term value of r is invariant with respect to t1..t3. In a low-tax environment in which the National Debt increases geometrically over time, it is not obvious to me that r will stay constant or increase over time. It is plausible that the long-range value of r would be higher in a moderately higher tax rate environment.

Following Mankiw's logic, Warren Buffett would have never started investing.

For the life of me I can't understand any discussion dealing with tax reductions when I see the real issue as being over spending by the federal government. It seems as if this particular issue is never addressed by the media or elsewhere.

When was the last time the white house or members of Congress actually owned a company that hired people and put them to work verus talking about job creation that they have nothing to do with!!! any thoughts would be appreciated.

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